The Developments So Far

The GEM's debut was merely ahead of the tech stock bubble peak in 2000 by five months. Since then it had dropped precipitously for three consecutive years, which was the lesser of a problem as high growth and high risk investments usually imply high volatilities, just like the US Nasdaq index. The GEM's weakness, nonetheless, was manifest in its 25% increase in 2003 when the blue chip Hang Seng Index rose by 35% in that year. Investors, bearing greater risks in a bear market, would demand greater rewards in a bull market. The Nasdaq's 50% surge in 2003 handsomely beat the Dow and the S&P's 25% rise. The GEM's weaker rally was a setback for investors, setting off a series of other problems.

An area of success of the GEM is its ever-increasing numbers of listed companies, which have grown steadily from 54 in the first year to the current 199. But because of the much weaker price movements of the stocks, the GEM's total market capitalization has nudged higher from HKD67.3bn to HKD72.7bn for the same period, leaving the impression that the GEM could only manage to grow quantitatively instead of qualitatively, failing to transcend itself along the way. When compared to the main board's HKD5482.6bn market cap, the GEM's is only 1.33% of its size.

The GEM's ability to maintain high P/E ratio is a double-edged sword. While it is favorable to attract more IPOs in the primary market, it might become a deterrent in the secondary market. Moreover, except for 2002, the GEM's daily average turnover has been on a steady downtrend. In 1H04, the daily turnover was only HKD149mn or less than 1% of that of the main board and less than half of the HKD341mn reached in its first year of debut. This poses serious problems as a quiet secondary market in turn diminishes the attractiveness of the primary market.

Vertical Challenges: Recognition, Turnover, and Liquidity

The latest development of leading GEM companies seeking to move to the main board highlights the declining degree of recognition of both the listed companies and the market in general. It was reported that CK Life Sciences International, Tom Group (it had successfully moved to the main board on August 4, 2004), Phoenix Satellite Television Holdings and Hongkong.com have either applied for or entertained the idea of moving to the main board. As they were the 1st, 2nd, 3rd and 6th largest stocks (in terms of market cap) of the GEM by the end of June, they accounted for 36% of the GEM's total market cap and more than 20% of total turnover, the impacts of their departures would be significant. Their decisions are most likely related to the main board's relaxing of the listing rules in April this year, which enables large companies with market cap between HKD2bn and HKD4bn to be exempted from requirements of three consecutive years of earnings if they pass certain asset and income tests. The main board's decision was aimed at increasing its attractiveness to companies. But it also creates incentives for qualifying companies of the GEM to contemplate moving their listings.

The relatively quick decisions by the four leading GEM companies to seek main board listings after the rule changes more or less reflect these companies' as well as the market's higher confidence in the main board in terms of reputation, turnover and attractiveness to investors. Although the GEM has successfully listed more companies over the years, they are unlikely to make up for those departing leading companies. As a result, the GEM has constantly been put under the defense. And its ambition to eventually rival the main board is in serious doubt. In the Nasdaq, although the heavyweight Microsoft and Intel become constituent stocks of the Dow Jones Industrial Average, they have never sought to jump ship to the rivaling NYSE, which maintains the Nasdaq's prestigious status. This demonstrates that retaining high quality companies is of utmost importance to a board, failing which shows the lack of investor confidence.

The GEM's lack of turnover and liquidity will probably worsen at the departures of those leading companies. The ratio of its daily turnover to that of the main board has fallen from 2.77% in its first year of debut to the current 0.90%. This poses serious challenges to attracting companies and investors. For example, institutional investors usually screen stocks using historical turnover as a criteria to ensure ample liquidity against price loss in case they have to liquidate a position. When comparing the monthly turnover to the total market cap, the GEM's ratio of 5-6% in the past three years is much lower than the Nasdaq's 20%. If persisting, investors are likely to form the impression that the GEM is a secondary market, hindering its breakthroughs.

Horizontal Challenges: Main Board, Shenzhen, Singapore and Consolidation

The four GEM companies' decisions to switch board are most likely business ones, taking into consideration of opportunities and costs. And if the main board goes further by simplifying switching rules and relaxing disclosure requirements, the ensuing switches will probably offset efforts by the GEM to recruit more companies. In other words, the main board is gaining strength at the expense of the GEM. Although the decisions to switch board are commercial ones made by the companies, and they are more suitable to further business expansions, the change of the main board's listing rules challenges the status quo of the two boards. Besides, the main board also hosts hundreds of small and illiquid stocks. Even though they may not all be tech stocks, they offer investors/speculators with alternative investment vehicles in the high risk, high reward arena. This also competes against the GEM for investment capitals.

Just like the main board, the GEM is working hard to attract more Chinese companies. The current headcount is that 30 out of the 199 GEM companies are Chinese enterprises. And out of the HKD5bn in IPO funds raised in 2003, HKD1bn or 20% are raised by state owned, privately owned and red chip companies. The launch of Shenzhen's SME board will undoubtedly increase the competition in this area. Although potential supplies seem unlimited, i.e. there are millions of registered SMEs in China and 1200 are ready to be listed, the exclusive status that the GEM used to enjoy to list Chinese SMEs will diminish if Shenzhen's SME board matures, becomes independent and relaxes its listing rules. So far, there has been little overlap of the two boards. The currencies of funds raised are different. The GEM offers an international funds platform and development path while Shenzhen is still a pure domestic play. Shenzhen's SME board is only a sub-board, employing the main board's more stringent listing rules, requiring longer approval time, but is relatively more efficient in terms of costs and refinances.

And then, competitions from Singapore cannot be overlooked. The Singapore Stock Exchange has wasted no time luring Chinese SMEs. The incentives it provides include the specially designed small S/A share model, relaxation of listing rules to exempt certain requirements in earnings, operations, local shareholding company structure and continuity of managements, etc. As a result, there are 45 Chinese companies listing in the SGX so far, up by 11 in 1H04 and accounting for 40% of this year's IPOs. In such ways, Shenzhen, Hong Kong and Singapore all vie for the Chinese SMEs' listings.

Besides direct competitions from other exchanges, the GEM is also under the global consolidation pressure. In 2003, according to Grant Thornton's report, there were seven sub-boards around the world that had either been shut down, changed to a stock index or OTC market. The GEM has survived the consolidation thanks to its efforts and the support of the China factor that continue to boost the numbers of listing companies and the total market cap. Though shutdown or reorganization is not the issue for now, the pressure could reemerge if the GEM's development remains stagnant.

The GEM's Development Strategies

Facing multiple internal and external challenges, it is time for the GEM to review its positioning and development strategies. First of all, the bottoming of global tech stocks has defeated the threat on the GEM's existence. But questions linger on whether it should still be positioned to become a tech heavy board that mirrors the Nasdaq and rivals the main board, or it should serve as a host for companies not yet qualified for main board listings. Judging from the current situation, the latter positioning seems to be the order. As for the ambitious former positioning, the market condition poses serious challenges. Although the GEM can facilitate growth by utilizing tools such as listing rules and policies, it is still largely the market force that decides the fate of a listed company.

Even so, the GEM still has room for improvement and development. The first task in order is to retain high quality companies in order to rebuild the market and investors' confidence. Instead of trying to prevent desertions using administrative measures or manipulating listing rules, the GEM must strive to provide some of the advantages similar to those of the main board in order to retain loyalties of the listed companies. A thorough survey on those companies having moved or moving to the main board will provide invaluable answers. Moreover, increasing liquidity and turnover is very important to attract investors and capitals, especially institutional investors. But it must be pointed out that unless the GEM dramatically raising the bar of listing, increasing the minimum requirements of funds raised and ratio of public shareholding, which have far fetching implications, the GEM will still host many small and illiquid companies. In this case, those mid to large size companies should be selectively targeted when considering measures to boost turnover. A market making system can be adopted, just like what the bond market has done. However, there exist many technical issues regarding a market making system for so many different stocks, as many large shareholders of an illiquid stock could easily act as a market maker. And ultimately the deciding force lies in a company's quality and market's selection, which is less relevant to whatever the GEM can do.

As it is inevitable that some GEM companies will seek to move to the main board once it achieves certain growth, the GEM needs to consider establishing a echelon relationship with the main board, under which qualifying GEM companies move up to the main board, and in turn the main board raises the criteria for continuous listing and sends those second, third or even fourth liners to the GEM under a delisting mechanism. Although the GEM will inherit weaker companies from the main board, this mechanism can partially solve the main board's delisting problem and stop the GEM's blood loss. And the echelon formation bodes well for optimizing the structure of the overall market and facilitating its development. The GEM also needs to review its own delisting mechanism in order to improve quality. Like the Nasdaq that delisted 430 or 11.4% of its stocks in 2003, its market cap grew by USD208bn or 9.3% nonetheless, proving that quality is worth pursuing. Of course, market practitioners and investors must be thoroughly consulted for this matter to avoid the plight of the penny stock crisis.

Lastly, in order to fend off external competitions, the GEM needs to differentiate its strategies. As Singapore competes for private Chinese enterprises mainly by lowering costs and entrance requirements, the GEM can leverage on its economic and geographic relationships with China, coordinate with the central government's favorable policies to promote our market. It should target higher quality companies with better reputation and services. As for the relationship with Shenzhen, the GEM must differentiate its developments. Otherwise once China further opens up its financial sector and the SME board evolves, direct competitions will emerge. Shenzhen's SME board is an important step to China building and perfecting its capital market. In order to plan and prepare for its launch, Shenzhen's main board suspended new listings for three years. Under the circumstance that the GEM is not in the central government's planning for China's capital market development, the SME board will continue to develop, expand and become more competitive along the way. Therefore, the GEM has no other choices but to establish a partnership with the SME board and differentiate its own developments. The proposal of one board, two markets is a feasible one. But it needs the consensus of the two exchanges and the approval of the central government. Even though it cannot be implemented right away, its spirit can still be reflected in the cooperation between the two exchanges in many aspects. The GEM processes the advantages of opening to international markets, capitals, investors, accounting standards and supervisions. And Shenzhen excels in convenience and localization. The two can establish a partnership by swapping shares, jointly launching promotions and road shows, and emphasizing different advantages to attract Chinese SMEs. A referral mechanism can also be established. Moreover, Hong Kong can help Shenzhen further develop its stock market by utilizing its expertise in stock derivatives. As the supply of Chinese SMEs seems unlimited, the two exchanges should have ample room for development. Shortsighted vicious competitions should be avoided at all costs.

Dai Daohua
Senior Economist